I’ve read that many banks want a certain level of inflation and I don’t really see why. Why is important to banks that a stable product costs more tomorrow than today?
Is it to make people spend their money more since storing it will eventually make is worth less?
In: Economics
That’s exactly it.
Consumer spending drives about 2/3 of the economy. Inflation helps ensure that money is being moved around instead of being held stagnant – this is required for an economy to work.
If you knew that in a year the cash stuffed in your mattress will be worth 3% less than it is now, you’d want to at least put it into an investment that gains 3% a year, right?
First, inflation is a dynamic outcome of economies. Thinking of inflation as simply “price increases” is not quite accurate. Aggregate price changes are the result of saving, spending and investing decisions of all the players in the economy. It isn’t a tank you fill once and let it remain stable. Instead it is producers constantly building new things, finding new ways to make things (better?) through investment and changing consumer demand – ie it is like a tank with lots of inflows and outflows.
What economic planners want to avoid is deflation which is generally a lot more destructive to economies. Generally speaking, this leads to a reduction in productive output of a society, and this generally builds on itself in a runaway spiral. The worst case outcome is stagflation where there is a combination of both rising prices and reduced output.
There is also a need to accommodate new consumers (population increases), workers as well as incentivize investment. These tend to work better in an environment with low inflation. Central banks therefore typically target something like a 2% inflation rate assuming that the actual rate will be somewhere close to that. Targeting 0% inflation means a high risk of deflation (ie negative inflation) if targets are missed.
Inflation encourages spending. Economies work because people interact with it, and exchange money. The worst thing to happen to an economy is if people simply stopped using it.
Inflation helps push that along, it encourages you to do something with your money, meaning spend it, not save too much.
Though its often easier to see from the opposite side: deflation. That means if I don’t spend my money, it will grow. That means the entire economy is better of not interacting with each other and sitting there doing nothing. No jobs, no spending, nothing, you just sit there. You can imagine how successful an economy would be if no one wanted to spend money on anything.
It’s impossible to maintain a currency at a perfectly stable value, and deflation is MUCH more damaging to an economy than inflation. Therefore, a currency fluctuating in mild inflation (under 3%) is generally seen as the ideal.
A small amount of inflation compels people to use their money, either spending it or investing it. This means money is either being injected into the economy through spending, or is available for businesses and people to borrow, which also generates economic activity.
In addition to encouraging people to keep their money moving in the economy, inflation also makes things easier for people who are in debt. As inflation grows, earlier debts become easier to pay off. While most individuals and companies will have interest rates that outpace inflation, some governments (like the US) have debt where the interest barely covers inflation, and sometimes is even less than inflation. This means that government debt can actually “shrink” over time due to inflation.
Ladies and gentlemen, the government wants inflation so the loans it took out from the reserve (1.9 trillion or whatever it was this year in the US) will not actually be 1.9 trillion when they actually have to pay it back. The loan will decrease, not number wise but value wise, over the term of the 30 year loan. So while they took out 1.9 trillion, when they have to pay it back that exact 1.9 trillion is worth drastically less.
The answers here are wrong, it is not to encourage spending. I would encourage anyone to ask questions on /r/AskEconomics, where there is actually high quality standards.
An economist wrote a longer, more complicated explanation [here](https://pastebin.com/p0AEbSnS). The basic ELI5 is that there are several competing factors, and about 2% per year (what most developed countries target) is a decent compromise between those factors. I wish I can write an ELI5 of some of those factors if anyone really wants, but it’s going to get pretty long and likely can’t fit within an ELI5 level.
It’s not, really, not universally. Whether it’s desired or not depends on the nature of your income.
Policy makers will tell you that inflation is important to promote spending, but this is false. It has nothing to do with promoting spending, versus savings. This is because if all you wanted to do was save money, there are non-cash vehicles you can put your money into, and even if the inflation rate were *zero*, you would still be better rewarded by putting your money into an asset which yielded you returns on your investment than simply stuffing your stable cash into a mattress.
This is why the price of gold drops when the economy starts to pick up. Gold is perceived as having stable value in bad economic times (and all value is really perception. Without a buyer, a price is a wish). As opportunities for greater returns arise, people will dump gold, and buy those assets.
The actual function of inflation is to give your society’s workers a pay cut, without telling them, they’re getting a pay cut. Here’s a pertinent quote by John Maynard Keynes, one of the most influential economists of the 20th century (and an advocate of the moderate inflationary policies we see today):
>Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth.
So, as inflation increases, wages, rents, and loans become gradually less expensive over time. If you’re a wage-earner, lender, or landlord, this is bad news, because the buying power of your income is persistently sapped away. By contrast, if you’re an employer, renter, or borrower, the effects of inflation can redound to your benefit. In practice, the stable inflation system is factored in by sophisticated economic actors, and overlooked by those who don’t understand the mechanism and its effects.
However, one thing you must understand about monetary policy is that it is a very imprecise instrument. The ability of central banks to control consumer spending trends or business plans is incredibly limited and unpredictable. While it’s not correct to say these institutions have *no* effect, the efficacy of their policies is quite suspect, and frequently disputed. What is **NOT** disputed, however, is that while moderate inflation is relatively innocuous for an economy, **DEFLATION** is catastrophic.
Picture a scenario where the longer you sit on you paycheck, the more you can buy for it. Now imagine that everyone is aware of the dynamic, and so the entire economy is busy hoarding cash, in anticipation of some future day where their money is worth more and more. The result of this condition will be that suddenly everyone’s income stream dries up. Stores no longer sell products, and they must now cut staff. Staff no longer receive paychecks, and so they can no longer make rent. Landlords no longer collect rents, so they must cut pack personal spending, you swiftly have a vicious cycle where the reciprocal engine of commerce seizes up.
So, the real reason the Federal Reserve has a stated 2% inflation target is actually to ensure that, given the lack of predictability of their rate changes, we never dip into deflation, triggering a huge economic contraction.
To add on to what people are saying, inflation is also a byproduct of a good economy. Imagine an economy at full employment with the rising wages. As wages rise, people are going to naturally spend more money. When firms notice increased revenues, they’re going to increase their prices to match demand. It’s not so much that banks are trying to create inflation, they’re trying to create good economic conditions that naturally result in inflation.
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